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Wednesday, October 8, 2014

The Alchemy of Finance

One of the books that I’ve often seen respectable financial writers include on their reading list is George Soros’s The Alchemy of Finance: Reading the Mind of the Market. These recommendations along with Soros’s incredible success as an investor were enough to tempt me to read this book. I found it interesting in parts, but seriously doubt that it will help me as an investor.

Soros’s main theme is his idea that people’s collective biases do more than just drive prices; they actually change outcomes. He calls this “reflexivity.” To take a simple example, suppose XYZ Company is overpriced and short-sellers are just waiting for their profits. But then XYZ uses its overpriced stock to buy a fairly valued company, increasing XYZ’s total profits. The market then overvalues this increase in profits, and XYZ makes another acquisition with its over-priced stock.

The high valuation on XYZ is self-fulfilling. XYZ keeps using stock to buy other companies cheaply. The short sellers get burned even though they were right that XYZ’s original business was overvalued. This is an example of self-reinforcing reflexivity. The market’s bias for XYZ was the reason for XYZ’s success. Soros also offered examples of self-defeating reflexivity. Reflexivity “is like shooting at a target when the act of shooting moves the target.”

Soros says that reflexivity is the reason why economic theory based on finding equilibria doesn’t apply in the real world. “Far from being always right, [the market] always incorporates the prevailing bias.” Market bias can change quickly preventing the market from finding equilibrium. “The stock market is generally believed to anticipate recessions: it would be more correct to say that it can help to precipitate them.”

Much of the book focuses on studying and trying to predict macroeconomics. Soros gives a number of interesting insights into why events in the 1980s played out as they did. In fact, Soros made a great deal of money betting on his ideas. However, when I try to apply Soros’s ideas to modern times to see if I have any insights that could be profitable, I draw a complete blank; everything seems uncertain.

The book isn’t without some humour. The dedication: “To Susan, without whom this book would have been ready much sooner.” Another instance: “President Reagan, despite his intellectual limitations ...”

A common prediction at the time was that the amazing rise of Japan as an economic superpower would continue. Soros was not immune. “Japan has already taken over the role of the United States as the major supplier of capital to the rest of the world and it is only a question of time before the yen takes over as the major reserve currency.” It hasn’t worked out that way. “The historic significance of the Crash of 1987 lies in the fact that it marks the transfer of economic and financial power from the United States to Japan.”

Despite the fact that I found much of this book interesting, I doubt that it will help many people become better investors. A possible exception is if it convinces some readers that they can’t be George Soros and should stick to safer ways of investing.

@Big Cajun Man: Actually, the use of "Alchemy" in the title is quite thoughtful. Soros uses it as a reference to the fact that social sciences cannot achieve the certainty of natural sciences because humans can make choices to act differently from any attempted scientific conclusion. He concludes that social sciences, and finance in particular, are not truly science. So he uses the word alchemy.

I've never read anything by Soros so can't comment specifically on the book. However, trying to predict macroeconomics would be a tough slog. Can we learn form the past? Do we? I find the whole subject of behavioural finance fascinating, as we seem to never learn from our mistakes. That includes governments at all levels not just individual investors.